Professional Documents
Culture Documents
Performance
Measurement in
Banking
S
uccessful bank operation requires managers to weigh complex
trade-offs between growth, return, and risk. In recent years banks
increasingly have adopted innovative performance metrics such as
risk-adjusted return on capital (RAROC) and economic value added
(EVASM)1, which assist managers in making such difficult and complex
decisions. These innovative measures all share as a basis the concept of
economic profit, rather than accounting earnings. By forcing line manag-
ers to include the opportunity cost of equity when making investment
and operating decisions, banks expect to elicit better decision-making by
managers. By implementing performance measurement and incentive
systems driven by economic profit and allocated equity capital, senior
managers also hope to align managerial behavior more closely with the
interests of shareholders.
This article analyzes the use of economic profit for measuring the
performance of banks. In particular, since economic profit cannot be
calculated without some imputation of equity, the article focuses on the
allocation of equity capital to products, customers, and businesses. The
first section of the article describes the use of economic profit to evaluate
performance, to price transactions, and to reward managers. The second
section describes in detail one performance measurement and incentive
Ralph C. Kimball system, known as EVASM, which has been adopted by a considerable
number of both banks and other companies. The third and fourth sections
discuss the shortcomings of performance metrics founded on economic
Economist, Federal Reserve Bank of profit, which may distort banks’ investment and operating decision-
Boston, and Associate Professor of Fi- making. These metrics assume that it is possible to allocate earnings and
nance, Olin Graduate School of Busi- equity capital to lines of business, products, and customers in a way that
ness, Babson College. The author isolates the economic revenues and costs of each activity. However, if
wishes to thank Richard Kopcke, John lines of business are related, either in the production of output or in their
Jordan, and Eric Rosengren for helpful use of capital, then this isolation may not be possible, and these methods
comments. The opinions expressed are of measuring performance may mislead managers. The conclusion argues
those of the author and not necessarily that banks need to recognize the ambiguities inherent in the calculation of
those of the Federal Reserve Bank of economic profit and be prepared to create and apply multiple specialized
Boston or the Federal Reserve System. performance metrics.
I. Economic Profit and Performance Strategic Decision-Making
Measurement in Banks Businesses with different risk characteristics re-
Economists and accountants differ on the proper quire different proportions of equity to achieve the
definition of profit. To the accountant, profit is the same risk exposure. Evaluating businesses only on the
excess of revenues over expenses and taxes and is best level and rate of growth of their reported earnings
measured by earnings. To the economist, earnings fails to take into account differences in their use of
fails to include an important expense item, the oppor- equity, and the fact that shareholders may have dif-
tunity cost of the equity capital contributed by the ferent required rates of return reflecting the risk of the
shareholders of the firm. A firm earns economic prof- equity invested. Thus, when allocating scarce re-
its only to the extent that its earnings exceed the sources or when deciding to enter or exit a new line of
returns it might earn on other investments. Thus, business, managers compare a return on equity (ROE)
earnings will always exceed economic profits, and a for the business unit relative to an appropriate hurdle
firm can be profitable in an accounting sense yet cost of equity. Business units earning an ROE in excess
unprofitable in an economic sense.1 of a risk-adjusted opportunity cost of that equity are
This conceptual difference has important practical candidates to receive additional resources, while those
implications. If managers attempt to maximize earn- earning less than this opportunity cost of equity are
ings (or growth of earnings) rather than economic candidates for corrective action. In recent years, such
profit, they will invest additional units of equity calculations have been extended from lines of business
capital so long as the marginal contribution to earn- to products, distribution channels, and even customers.
ings is positive. But if they do so, the marginal
contribution of the last unit of equity capital will be
Pricing
zero and less than its opportunity cost, and the aver-
age return to equity capital may be greater or less than As noted above, different products, customers, or
its opportunity cost depending upon how much eq- transactions will absorb different amounts of equity
uity is used. In contrast, a manager who maximizes capital, with larger and more risky transactions requir-
economic profits will add units of equity capital only ing more equity than smaller, less risky ones. To
until the marginal contribution of capital is equal to its ensure that a transaction is profitable, managers must
opportunity cost, and the average return to equity assign the appropriate amount of capital and a re-
capital will equal or exceed its opportunity cost. quired contribution to equity must be calculated and
As a result, firms that make business decisions incorporated in the price applied to the transaction.
without explicitly incorporating the opportunity cost This use of allocated capital to ensure adequate pric-
of equity will be inefficient users of equity capital, ing was first implemented by Banker’s Trust in its
engaging in investment projects that generate low RAROC system, which subsequently has been
returns to shareholders.2 In 1995, a year of robust adopted by many other commercial banks.
earnings, one study estimated that fewer than half of In the RAROC system, the required rate on a loan
the 1,000 largest industrial and nonfinancial firms comprises a cost of funds, a charge for non-interest
earned sufficient returns to cover their opportunity expenses, a premium for credit risk, and a capital
cost of capital (see Ross 1997). charge. The great contribution of the RAROC system
Banks and other companies have begun to ad- was to include explicit charges for both the credit risk
dress this issue by incorporating an explicit opportu- premium and the use of capital. By doing so, it ensures
nity cost of equity into their decision processes. In that banks price individual loans to cover credit risks
particular, a number of banks have incorporated a and generate an adequate return for shareholders. An
measure of economic profit in three key areas: strate- example of the use of the RAROC system to price
gic decision-making, product pricing, and perfor- loans is shown in Table 1. The capital charge is
mance evaluation and incentive compensation. determined as the product of the proportion of equity
capital assigned to support the loan and the required
1
EVASM is a registered servicemark of Stern Stewart & Co. pre-tax hurdle rate on equity. As shown in Table 1, a
2
While conventional capital budgeting models such as net loan rate of 11.25 percent will permit the bank to earn
present value or internal rate of return explicitly include a cost of a 15 percent return on the equity required to back the
equity capital, many decisions taken outside the capital budgeting
process, such as product pricing or entry or exit from a particular loan. If the bank can obtain a rate greater than 11.25
line of business, may not. percent, then it will earn an economic profit, while a
In cases where subunits generate substantial effective they are in identifying and quantifying
externalities, implementation of an incentive com- externalities, the more complex they become. If the
pensation system based on subunit profitability can level of activity in one business unit affects multiple
lead to perverse results by encouraging managers other units, any incentive scheme that accurately
to ignore the effects of their actions on other sub- reflects this becomes immensely complex and un-
units. This adverse effect has long been recognized, wieldy. Even if the average impact of one unit’s
and a variety of approaches have been developed to activities on the rest can be determined, the mar-
address it. They can be summarized as linked incen- ginal impact may vary from transaction to transac-
tives, hierarchical grouping, and hybrid systems. tion, so that any simple cross-linkage scheme will
Linked Incentives fail to elicit efficient decision-making.
No incentive compensation
Hybrid Systems
system is perfect, and many
Yet another approach is to expand the perfor-
mance measurement system to include nonfinancial
firms and banks end up using a
variables. For example the “balanced scorecard” combination of systems.
approach measures managers in areas such as
“leadership,” “customers,” and “people,” as well as
the more traditional financial goals. Such a scheme generate only 900 transactions accounts but an
can address the issue of relatedness by including EVASM of $110,000, or 1,100 transactions accounts
key operating measures that affect other business and an EVASM of only $90,000?
units. These key operating measures might be the While the efficacy of incentive compensation
number of new customers added or the number of systems in encouraging managers to capture the
leads generated for other areas of the bank. For effect of cross-unit synergies can be increased in a
example, if, as shown earlier in Figure 1, the origi- number of ways, none is perfect and most involve
nation of new transactions accounts has posi- costs of their own. Many firms and banks end up
using a combination of hierarchical groupings, hy-
b
This approach does not completely avoid conflict. Subunit brid performance measurement systems, and
managers have an incentive to cooperate with the group man- linked incentives to address this issue. Such inte-
ager until the group goal is achieved. At that point the conflict grated systems must be carefully constructed and
between the subunit manager’s objective to maximize subunit
EVASM and the group manager’s objective to maximize group monitored to ensure that they have a positive effect
EVASM reemerges. on the overall performance of the bank.
probability of insolvency for the bank’s consumer calculate the Z-ratio for each line of business and for
lending business than for its mortgage origination the bank as a whole. As shown there, the Z-ratios
business. One index of the probability of insolvency is differ significantly across the lines of business, with
the Z-ratio,15 defined as: the credit card business having a substantially lower
Z 5 (ROA* 1 K)/sROA (1) probability of exhausting its assigned equity than do
the mortgage banking and subprime lending busi-
where nesses.
ROA* 5 the pretax expected return on assets, An alternative approach allocates equity capital
usually defined as the historical mean ROA, based on each business’s cash flow so as to create an
K 5 the ratio of equity capital to assets, and equal probability of insolvency. Equation (1) above
sROA 5 the standard deviation of ROA. can be rewritten to express the capital-to-asset ratio
required to achieve a given target Z-ratio, as follows:
Thus, the Z-ratio is a function of the normal profit
margin of the bank, the variation in that profit margin,
K* 5 Z*sROA 2 ROA* (2)
and the equity capital available to absorb that varia-
tion. In effect, the Z-ratio measures the number of
where K* is the required capital-to-asset ratio to
standard deviations by which ROA would have to
achieve a target Z-ratio equal to Z*. In this approach
decline before the book equity capital of the bank
would be exhausted. The relationship between the each line of business will be allocated capital until its
Z-ratio and the probability of insolvency is an inverse Z-ratio equals Z*. Application of this approach to
one, with higher Z-ratios indicating a lower probabil- Consolidated Amalgamated is illustrated in Table 3,
ity of insolvency.16 The last four columns of Table 2 which assumes that each line of business is allocated
capital to achieve a Z-ratio of 13.8, the initial Z-ratio of
15
the credit card business. This approach results in
This measure was developed by Hannan and Hanweck substantially higher equity-to-asset ratios for the mort-
(1988). Although Hannan and Hanweck called the risk index “g,” in
subsequent work it has generally been called “Z.” gage banking and subprime lending businesses. In-
16
If the assumption is made that the potential ROAs of the deed, the equity capital-to-asset ratio of the subprime
business are normally distributed, then the one-period probability
of insolvency can be calculated as a function of the Z-ratio: lending business increases from about 33 percent
p 5 1/[2Z2] under the peer-group method to about 95 percent
However, empirical studies indicate that ROAs are not normally
under the equal probability of insolvency approach.
distributed, but instead are “fat-tailed,” so that the actual probabil- Similarly, if the required equity of the bank as a whole
ity of insolvency may be greater than that calculated using the is the sum of the required equity for each of the lines
assumption of normality. Moreover, this one-period probability
may understate the true probability of insolvency because it mea- of business, then the bank will require almost 89
sures the risk of a single-period loss being so large it wipes out percent more equity under the equal probability of
equity. In reality, insolvency often occurs after a sequence of smaller
losses occurring over several periods, indicating that serial correla- insolvency approach than under the peer group ap-
tion between negative shocks may exist. proach.
Allowing for Diversification cation, the more difficult it is for a line of business to
earn an economic profit. If capital allocations to indi-
A comparison of the Z-ratios for the bank as a vidual businesses exceed the actual capital of the
whole with the Z-ratios for the individual lines of bank, then managers may believe this “ghost capital”
business, as shown in Tables 2 or 3, reveals a draw- unfairly biases downward the reported return on
back to both of these stand-alone methods of allocat- equity of each business. The excess allocated capital
ing capital. The Z-ratio for the bank as a whole is can also create strategic issues, since the reported
considerably greater than the Z-ratio for any of the EVASMs of the business units will not sum to the
three lines of business, indicating that the probability EVASM of the bank. Theoretically it would be possible
of insolvency for the bank is less than that of any of the for each line of business to fail to earn its required
lines of business. This occurs because the correlation opportunity cost of stand-alone equity, while the bank
in the ROAs of the individual businesses is less than as a whole surpassed its required opportunity cost of
perfect. To the extent such correlations are less than equity based on actual equity capital, which includes
perfect, they will tend to dampen the fluctuations in the effects of diversification. In extreme cases, a bank
returns for the bank as a whole, so that the risk of the might choose to exit a business based on an insuffi-
bank will be less than the weighted sum of the risks of cient return to equity earned on allocated capital,
the individual businesses. In effect, the business units when the return on equity on actual capital might be
act as partial natural hedges for each other, reducing quite satisfactory.
the need for equity capital. Thus, a bank with a
diversified portfolio requires less equity capital to
Proportional Scaling
achieve any given probability of insolvency than do
the business units on an aggregated stand-alone basis. This problem can be addressed in two ways. The
This is shown at the bottom of Table 3, where the simplest is to scale back the allocations to the individ-
amount of equity capital needed for the bank as a ual businesses so that the sum of the allocations equals
whole to achieve a Z-ratio of 13.8 is calculated to be the actual (diversified) capital of the bank. Thus, if the
only $4.3 billion, less than half of the $10.6 billion sum of the individual allocations is 200 percent of the
calculated as the sum of the stand-alone allocations to actual capital of the bank, each allocation is reduced
the individual businesses. by one-half to make the sum of the individual alloca-
Thus, in those situations where the ROAs of the tions equal to actual capital. This approach is illus-
individual businesses are imperfectly correlated, a trated for Consolidated Amalgamated in Table 4,
discrepancy will result between the sum of the indi- assuming that each line of business has the same
vidual equity allocations to the different lines of busi- probability of insolvency (from Table 3) and that the
ness and the equity capital required when the effects bank as a whole has a target Z-ratio of 13.8. In effect,
of diversification are incorporated. This discrepancy this approach spreads the reduction in equity capital
creates obstacles to the evaluation of businesses and due to diversification across the lines of business in
their managers. Ultimately, the larger the capital allo- proportion to their initial stand-alone capital allocations.
While simple to implement, this approach to positive correlation. A simple proportional reduction
incorporating the effects of diversification has serious in stand-alone capital tends to over-allocate capital to
conceptual drawbacks. By allocating the reductions in lines of business units with low or negative correla-
equity capital in proportion to the initial stand-alone tions, and to under-allocate equity capital to business
capital allocations, inefficient users of capital receive a units with high positive correlations.
disproportionate increment to their economic profits.
An example of this is shown in Table 5, which Internal Betas
compares three lines of business before and after the
scaled reductions in stand-alone allocations.17 All A second possible alternative to incorporating the
three lines of business have the same adjusted earn- effects of diversification in allocating capital is based
ings, but they differ in the amount of capital used and upon the concept of “internal betas.” In this approach,
thus in their reported economic profits. If stand-alone the relative risk contribution of each line of business is
capital allocations are scaled back by 50 percent to calculated as an internal beta, defined as the ratio of
reflect the benefits of diversification, then the incre- the covariance between the business unit’s and bank’s
mental effect on the reported economic profits of returns to the variance of the bank’s returns:
Business A, the most inefficient user of capital, will be
double that of Business C, the most efficient user of bBus 5 cov(Rbus, Rbank)/s2Bank 5 (sBus/sBank)rBus,Bank
equity capital. As a result, the simple scaling approach
where sBus and sBank are the standard deviations of
obscures the ability of senior management to distin-
the ROAs of the business unit and the bank as a whole,
guish among the business units in their efficiency in
respectively, and rBus,Bank is the coefficient of correla-
using equity capital.
tion of returns between the business and the bank. In
Moreover, when the benefits from diversification
this formulation the risk contribution of each business
are allocated in proportion to their initial stand-alone
will depend on two factors, its stand-alone risk rela-
capital allocations, they are being allocated in propor-
tive to the bank as a whole (sBus/sBank) and the degree
tion to the stand-alone total risk of each line of
of correlation between the returns of the business and
business, weighted by the dollar assets of each busi-
the bank (rBus,Bank). The effect of the correlation in
ness. But the contribution of a particular line of
returns is unambiguous—the greater the correlation,
business to the total risk of the bank will depend not
the greater the risk contribution of the business— but
only on the stand-alone risk of that line of business,
the effect of the stand-alone risk of the business will
but also on the correlations in returns among the
depend on the sign of the correlation coefficient. If the
different lines of business of the bank. A line of
correlation between the unit’s and the bank’s returns
business with a low or negative correlation of returns
is positive, then the risk contribution of the business
with the other parts of the bank will diversify away
will increase in proportion to its stand-alone risk, but
more risk than will a line of business with a high
if the correlation in returns is negative, then the risk
17
contribution of the business will decrease as the stand-
The lines of business shown in Table 5 are fictional and are
not those shown for Consolidated Amalgamated in Tables 2, 3, 4, 6 alone risk of the business increases. Intuitively, if
and 7. returns are negatively correlated, then variations in
returns from the business tend to offset variations in that the internal beta approach is most appropriate in
returns on the bank as a whole, and the greater the a relatively static situation and results in biased allo-
variation in returns on the business (sBus), the greater cations in more dynamic situations such as acquisi-
the reduction in the overall risk of the bank. tions or divestitures, or where business units are
In the internal beta approach, the equity capital- growing at different rates. Thus, in situations where
to-asset ratio for each business unit is equal to the the mix of businesses is changing, as a result of either
product of the unit’s internal beta and the bank’s strategic decisions or differential growth rates, capital
overall equity capital ratio: should be allocated based on the business’s marginal
risk contribution.
KBus 5 bBusKBank
Marginal capital can be defined as the incremen-
where KBus is the capital-to-asset ratio of the business, tal capital (for the bank as a whole) resulting from a
bBus is the internal beta of the business, and KBank is change in the scale of operation of a business unit,
the capital-to-asset ratio of the bank, including diver- assuming the probability of insolvency remains con-
sification effects. This approach is illustrated for the stant. For an acquisition or divestiture, marginal cap-
Consolidated Amalgamated Bank in Table 6. As can ital is measured as the difference between the required
be seen there, the capital allocations under this ap- equity capital for the bank as a whole, including the
proach differ substantially from the equal-scaling ap- business being bought or sold, and the required equity
proach shown in Table 4. In particular, the business capital for the bank without the line of business. For
units with relatively low correlation in returns (mort- an existing business that is expanding its scale of
gage banking and subprime lending) are allocated operations, it can be measured as the incremental
substantially less equity capital under this approach capital for the bank as a whole associated with the
than the business unit (credit card) with a relatively incremental increase in volumes.
high correlation in returns. Marginal capital for each of the lines of business
of Consolidated Amalgamated Bank is shown in Table
7 under the assumption that each line of business is
Marginal Capital
being divested. That is, marginal capital is calculated
While the internal beta approach integrates both as the difference in the bank’s required capital, with
the stand-alone risk of the business and its interaction and without the line of business in question. As can be
with the rest of the bank, its use to calculate the risk seen in Table 7, marginal capital depends both on the
contribution of a business unit involves several restric- extent of the correlation in returns between the busi-
tive assumptions. As discussed in the accompanying ness units in question and on the effect of the change
box, the internal beta approach measures the risk on the diversification of the bank.
contribution of a business unit under the assumptions Adding a business that has a low positive corre-
that the business already exists within the bank and lation with existing businesses will require less incre-
that the relative size of the business (and of the other mental capital for the bank than will acquiring one
businesses in the bank) does not change. This means with a high positive correlation, and acquiring a
business with a negative correlation with existing associated with a given increment in the size of a
businesses can actually reduce the required capital, business increases as the business unit becomes a
resulting in negative marginal capital. This is shown larger proportion of the bank.
in Table 7 for the mortgage banking business. Because
the correlation in returns between the mortgage bank-
Capital Allocations and EVASM
ing business and the subprime lending business is
negative (20.53), adding the mortgage banking busi- Table 8 summarizes the results of Tables 2, 3, 4, 6,
ness to an existing combination of the credit card and and 7 and shows the equity capital allocated to each of
subprime lending businesses actually dampens the Consolidated Amalgamated’s three businesses using
variation in the aggregate and therefore reduces the each of the capital allocation methodologies discussed
required capital. Moreover, marginal capital is not above. Depending on the methodology selected, the
constant but will vary as the size of the business in allocated equity capital, and thus the reported EVASM,
question varies relative to the size of the other busi- of a business unit can vary dramatically.
nesses in the bank. As discussed in the box, “Internal Clearly the capital allocation methodology se-
Betas and Marginal Capital,” the marginal capital lected will affect not only the reported EVASM of each
Table 8
Equity Capital Allocations for Consolidated Amalgamated Bank, by Allocation Methodology
(1) (2) (3) (4) (5)
Stand Alone:
Stand Alone: Equal Probability Scaled
Business Peer Group of Insolvency Diversification Internal Betas Marginal Capital
Unit ($millions) ($millions) ($millions) ($millions) ($millions)
Credit Card 2,018 2,018 822 1,526 767
Mortgage Banking 1,989 3,779 1,540 1,217 (683)
Subprime Lending 1,666 4,827 1,967 1,586 368
Unallocated Capital 3,877
Table B-1
Risk Contribution By Business Unit: The Internal Beta Approach
Business
Unit 1 2 3 N
1 w1 s1
2 2
w1w2cov1,2 w1w3cov1,3 — w1wncov1,n Risk Contribution 5 w1Swj cov1,j 5
w1cov1,Bank
2 w2w1cov1,2 w22s22 w2w3cov2,3 — w2wncov2,n Risk Contribution 5 w2Swjcov2,j 5
w2cov2,Bank
3 w3w1cov1,3 w3w2cov2,3 w32s32 — w3wncov3,n Risk Contribution 5 w3Swj cov3,j 5
w3cov3,Bank
— — — — —
Marginal Capital
Because a disproportionate change in the activ-
ity of one business unit affects the risk weighting of
all of the business units, the incremental change in
the total risk of the bank is not just the increment in
the risk contribution of the particular business unit the weightings of unit 1 and 2 to achieve the same
initiating the change, but also includes the effects on probability of insolvency and is thus an iso-insol-
the risk contributions of all of the other business vency curve. It is convex because the returns of the
units in the variance/covariance matrix. Except in businesses are assumed to be imperfectly positively
special circumstances this marginal risk contribu- correlated.
tion will not be equal to the risk contribution As shown in Figure B-1, each point on the
computed using internal betas. This is shown in iso-insolvency curve shows a different capital-to-
Figure B-1 for a bank consisting of two business asset ratio corresponding to a different mix of
units. Business unit 1 is relatively low-risk and business units. If the bank increases the size of unit
low-return, while business unit 2 is relatively high- 2 relative to unit 1 it will move to the right along the
risk, high-return. Figure B-1 shows the equity cap- curve and its required capital-to-asset ratio will
ital-to-asset ratio required to achieve a constant increase. The rate at which the required capital-to-
Z-ratio for different asset weightings of units 1 and asset ratio increases is equivalent to the marginal
2. At point A, 100 percent of the bank’s assets are capital ratio and can be shown as the slope of a
comprised of unit 1 and the bank’s required capital- tangent to the iso-insolvency curve. At point C, the
to-asset ratio is simply the stand-alone required required capital-to-asset ratio is OC, but the mar-
capital ratio for unit 1. At point B, 100 percent of the ginal capital is equal to the slope of the tangent at C,
bank’s assets are invested in unit 2, and the bank’s which is greater than OC. Thus, the marginal cap-
required capital-to asset ratio is simply the stand- ital ratio will not equal the capital ratio for the bank
alone required capital ratio for unit 2. The curve AB as a whole, nor will it be a weighted average of the
represents the equity capital-to-asset ratios for all stand-alone risk of each of the business units.
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